Definition
Free Cash Flow (FCF) is a measure of the cash generated or consumed by a company after deducting capital expenditures from its after-tax operating profit. While there is no universally accepted formula for calculating FCF, it is generally represented as:
\[ \text{Free Cash Flow} = \text{Operating Cash Flow} - \text{Capital Expenditures} \]
Some definitions also take into account changes in working capital. FCF is not defined by Generally Accepted Accounting Principles (GAAP) and should be viewed as a supplementary financial measure rather than a substitute for GAAP-determined metrics.
Examples
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Example 1: A technology firm generates an after-tax operating profit of $10 million. It also incurs $2 million in capital expenditure for new equipment. Thus, its Free Cash Flow is:
\[F= 10,000,000 - 2,000,000 = 8,000,000\]
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Example 2: A retail company has an operating cash flow of $15 million and capital expenditures amounting to $5 million. After adjusting for a $1 million increase in working capital, the Free Cash Flow is:
\[ F = 15,000,000 - 5,000,000 - 1,000,000 = 9,000,000 \]
Frequently Asked Questions
What is Free Cash Flow used for?
Free Cash Flow is used to gauge a company’s financial health and its ability to:
- Pay dividends to shareholders
- Reduce overall debt
- Acquire other companies
- Invest in new projects and opportunities
How does Free Cash Flow differ from net income?
Net income is the profit a company earns after all expenses, taxes, and costs. Free Cash Flow, however, focuses on cash that is truly “free” — available for use after capital expenditures necessary for maintaining and expanding the asset base.
Can Free Cash Flow be negative?
Yes, Free Cash Flow can be negative if a company’s capital expenditures exceed its operating cash flow. This could indicate the company is heavily investing in growth, but could also signal potential financial distress if negative FCF persists.
Why isn’t Free Cash Flow part of GAAP reporting?
Free Cash Flow is not included in GAAP reporting because GAAP aims to provide standardized, historical financial information. In contrast, FCF is more flexible and can be calculated in various ways, making it non-standardized.
How is Free Cash Flow related to discounted cash flow (DCF)?
Discounted Cash Flow (DCF) valuation method uses Free Cash Flow to estimate the value of a company. The future FCF is projected and then discounted back to its present value to determine the company’s value.
Related Terms
- Operating Profit: Earnings before interest and taxes (EBIT), representing a company’s profitability.
- Capital Expenditure: Funds used by a company to acquire or upgrade physical assets.
- Working Capital: The difference between a company’s current assets and current liabilities.
- Generally Accepted Accounting Principles (GAAP): A standard framework of guidelines for financial accounting.
- Discounted Cash Flow (DCF): A valuation method that projects future cash flows and discounts them to determine their present value.
Online References
Suggested Books for Further Studies
- “Free Cash Flow and Shareholder Yield: New Priorities for the Global Investor” by William W. Priest
- “Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports” by Thomas Ittelson
- “Financial Management: Theory & Practice” by Eugene F. Brigham and Michael C. Ehrhardt
Accounting Basics: “Free Cash Flow” Fundamentals Quiz
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